BM2003

ACCOUNTING FOR MANUFACTURING BUSINESS

Manufacturing is a type of business that processes direct materials into finished products. The costs in
manufacturing these finished products are classified as direct materials, direct labor, and manufacturing
overhead.
MANUFACTURING COSTS
There are costs every time a product is being manufactured. As an example, think about mobile phones.
In processing these phones, a factory will first gather the necessary materials such as case, keypad, LED
lights, screws, etc. These materials will undergo several processes through a machine with supervision
from workers operating that machine. After processing, finished products will be then made, packed, and
shipped to retailers.
In the example, the cost of case, keypad, LED lights are accounted as part of direct materials, the salary of
the factory workers are computed as the direct labor, and the screws and the utilities used in the factory
are part of the manufacturing overhead.

Direct Materials
These are raw materials that can be physically and directly associated with the finished product during
the manufacturing process. Examples include flour in baking, syrup in bottling of soft drinks, and steel in
making automobiles (Weygandt, Kimmel, & Kieso, 2018).
If raw materials cannot be associated with the finished product, then it is called indirect material.
According to Weygandt, Kimmel, and Kieso (2018), these indirect materials possess either of the two (2)
characteristics:
• they do not physically become part of the finished product (such as polishing compounds); or
• they are impractical to trace to the finished product because their physical association with the
finished product is too small in terms of cost (such as pins and screws).
Indirect materials are accounted for as part of manufacturing overhead.
Direct Labor
Direct labor refers to the work of factory employees that can be physically and directly associated with
converting raw materials into finished goods. Examples are bottlers at Coca-Cola, bakers at Pan de Manila,
and equipment operators at San Miguel Corporation.
If the work of employees has no physical association with the finished product or for which it is impractical
to trace costs to the goods produced, then it is called indirect labor. Examples include wages of factory
maintenance people, factory time-keepers, and factory supervisors. Like indirect materials, companies
classify indirect labor as manufacturing overhead. (Weygandt, Kimmel, & Kieso, 2018).

Manufacturing Overhead
Manufacturing overhead consists of costs that are indirectly associated with the manufacture of the
finished product. Overhead costs also include manufacturing costs that cannot be classified as direct
materials or direct labor. Manufacturing overhead includes indirect materials, indirect labor, depreciation
on factory buildings and machines, and insurance, taxes, and maintenance on factory facilities (Weygandt,
Kimmel, & Kieso, 2018).

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NONMANUFACTURING COSTS
The collective term for manufacturing costs is product cost, while nonmanufacturing costs are called
period costs. Period costs are matched with revenue for a specific period, rather than included as part of
the cost of inventory. Examples of period costs are selling, advertising, and administrative expenses. In
determining the net income, companies deduct these costs from revenues in the period in which they are
incurred (Weygandt, Kimmel, & Kieso, 2018).

PRODUCT COSTS VERSUS PERIOD COSTS

Figure 1. Product Cost versus Period Cost

In the figure, manufacturing costs are classified into two (2): the prime cost and conversion cost. Prime
costs are the direct costs of producing a product. These include direct materials and direct labor. On the
other hand, conversion costs are the cost incurred in transforming raw materials into finished products.
These include direct labor and manufacturing overhead.

Illustrative Example 1
Suppose Jake Carpenter started his skateboard factory, JC Skateboards. Jake initially experimented with
100 different prototype designs before settling on a final design. Along with two (2) relatives and a friend,
Jake started making 50 boards per day in San Pedro, Laguna. Unfortunately, while they made a lot of
boards in their first year, they were only able to sell 300 of them.
Here are some of the costs that JC Skateboards would incur.
1. The materials cost of each skateboard is P300.
2. The labor costs (e.g., to trim and shape each board using jig saws and band saws) are P400 per board.
3. Depreciation on the factory building and equipment (e.g., presses, grinding machines, and lacquer
machines) used to make the skateboards is P250,000 per year.

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4. Property taxes on the factory building where the skateboards are made cost P60,000 per year.
5. Advertising costs (mostly online and catalog) are P60,000 per year.
6. Sales commissions related to skateboard sales are P200 per skateboard.
7. Salaries for factory maintenance employees are P450,000 per year.
8. The salary of the plant manager is P70,000.
9. The cost of shipping is P80 per skateboard.

Requirement: Identify the correct classification of each cost by putting an ‘X’ mark in the corresponding
column (refer to item no. 1 as an example).

Product Costs
Direct Direct Manufacturing Period
Cost Item Material Labor Overhead Costs
1. Materials costs X
2. Labor costs
3. Depreciation on factory equipment
4. Property taxes on factory building
5. Advertising costs
6. Sales commissions
7. Maintenance salaries (factory facilities)
8. Salary of plant manager
9. Cost of shipping boards

COSTS CLASSIFICATION ON FINANCIAL STATEMENTS

The financial statements of the manufacturing business are almost similar to those of the merchandising
business. The principal differences between their financial statements occur in two (2) places: the current
assets section in the statement of financial position and the cost of goods sold section in the income
statement.
Cost of Goods Manufactured
The cost of goods manufactured is a schedule or statement that shows the total production costs for a
company during a specific period.

Beginning work-in-process (WIP) inventory

Add: Total manufacturing costs*
Less: Ending work-in-process inventory
= COST OF GOODS MANUFACTURED

∗ 𝑇𝑜𝑡𝑎𝑙 𝑀𝑎𝑛𝑢𝑓𝑎𝑐𝑡𝑢𝑟𝑖𝑛𝑔 𝐶𝑜𝑠𝑡𝑠 = 𝐷𝑖𝑟𝑒𝑐𝑡 𝐿𝑎𝑏𝑜𝑟 + 𝐷𝑖𝑟𝑒𝑐𝑡 𝑀𝑎𝑡𝑒𝑟𝑖𝑎𝑙 + 𝑀𝑎𝑛𝑢𝑓𝑎𝑐𝑡𝑢𝑟𝑖𝑛𝑔 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑

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Income Statement
Under a periodic inventory system, the income statements of a merchandiser and a manufacturer differ
in the cost of goods sold section. Merchandisers compute the cost of goods sold by adding the beginning
inventory to the cost of goods purchased and subtracting the ending inventory. Manufacturers compute
cost of goods sold by adding the beginning finished goods inventory to the cost of goods manufactured
and subtracting the ending finished goods inventory (Weygandt, Kimmel, & Kieso, 2018).
The following shows how the cost of goods sold is computed both in merchandising and manufacturing
business:

MERCHANDISING MANUFACTURING
Beginning inventory Beginning finished goods
inventory
Add: Purchases Add: Cost of goods
manufactured
Less: Ending Inventory Less: Ending finished goods
inventory
= COST OF GOODS SOLD

Reference
Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2018). Accounting principles (13th ed.). John Wiley & Sons.

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